The advantages of bond swapping

Investopedia

02/28/19

Bond swapping is the process of selling a bond and using proceeds from the sale to purchase another bond, in order to achieve specific investment objectives. There are several reasons why an investor would want to consider bond swapping or why a financial professional may advise it for a client, such as adding diversity to a portfolio, lowering taxes or taking advantage of anticipated interest rate changes.

Lowering taxes

Probably the most common bond-swapping purpose is to lower capital gains or ordinary income tax obligations. Bond swapping to lower taxes involves selling a bond that is trading below the price you paid to purchase the instrument and taking the loss to write-off a portion or all of the taxes owed on capital gains from other investments or ordinary income. At the same time, you would then purchase another bond investment with similar but different features (yield, maturity and credit rating). By swapping bonds under this scenario, you have the potential to both write-off a loss in order to save on taxes and re-invest in another similar instrument that will, hopefully, hold its value and produce the anticipated return upon maturity, enabling you to realize a later profit.

Before swapping in order to lower taxes, it's important to know if your potential gains and losses are short-term (on a holding of less than 12 month) or long-term (on a security held longer than 12 months). The difference affects how you can apply your losses (short-term losses will offset short-term gains and long-term losses offset long-term gains) and the rate at which you'll be taxed on profits (short-term gains are taxed at your ordinary income tax rate whereas long-term gains have a lower maximum tax rate). The status also affects whether or not you can carry forward any excess losses over the amount of your current tax obligations to apply to future tax bills.

It's also important to make sure that the new bond investment you choose has at least two different features (for example, maturity, issuer and coupon rate) from the original bond you're swapping in order to avoid a "wash sale," which would prevent you from claiming the loss. The IRS considers a bond swap a wash sale if the new bond you purchase - within 30 days before or after the sale of the original bond - is essentially the same as the one you sold to take the tax write-off.

Gaining a greater yield

Investors who want to increase the amount of potential return through their bond investments may choose to swap bonds by:

Improving quality

A bond's credit rating is often one of the most important factors for an investor. Swapping bonds to improve quality is when an investor sells one fixed-income holding with a lower credit rating for a similar one with a higher rating. Swapping for quality becomes especially attractive for investors who are concerned about a potential downturn within a specific market sector or the economy at large, as it could negatively impact bond holdings with lower credit ratings. Swapping into a higher-rated bond (say, from a Baa to an Aa bond) may be a relatively easy way to gain greater confidence that your bond investment will have a higher probability of being repaid, in exchange for a lower yield.

Maximizing or minimizing the effect of interest rate changes

Because bonds offer a fixed-rate of interest, holders can more easily compare potential gains (or losses) due to interest rate environment fluctuations. For example, if you anticipate a rise in interest rates, you may want to consider swapping longer-term bond holdings for shorter-term bonds in order to lower the potential impact on your overall bond portfolio value. In the same way, investors who are concerned about interest rate drops may decide to extend the average maturity of their portfolio.

Not all bonds respond similarly to interest rate changes, so it's important to know how the bonds you're holding best perform before you choose to swap. In addition, it's essential to appropriately gauge your risk tolerance, since bond swapping in anticipation of interest rate changes is speculative and the changes upon which you're basing your bond swap may not come to pass, resulting in a potential investment loss.

Conclusion

Though bond swapping can add diversity to a portfolio and potentially lower taxes, it's important to not rush into the world of bond swapping. Work with a professional financial advisor to ensure that your bond swap execution strategy helps you meet your investment goals and that you understand the tax implications of pursuing such a plan.

PLEASE READ THE IMPORTANT DISCLOSURES BELOW.

The material is being provided to you for educational purposes only. The content has been written by, and will be presented by, a third party not affiliated with E*TRADE Financial Corporation or any of its direct or indirect subsidiaries (E*TRADE). E*TRADE is not responsible for the content. No information presented constitutes a recommendation by E*TRADE to buy, sell, or hold any security, financial product, or instrument discussed therein or to engage in any specific investment strategy.

All bonds and fixed income products are subject to interest rate risk and you may lose money. Bonds sold by issuers with lower credit ratings may offer higher yields than bonds issued by higher rated or "investment grade" issuers, but are usually associated with higher risks. High yield bonds, also known as "junk bonds", generally have a greater risk of default, which increases the risk that an issuer may be unable to pay interest and principal on the issue. In addition, high yield bonds tend to have higher interest rate risk and liquidity risk, particularly in volatile market conditions, which makes it more difficult to sell the bonds. Before investing in high yield bonds, you should carefully consider and understand the risks associated with investing in high yield bonds.

Securities, investment advisory, commodity futures, options on futures and other non-deposit investment products and services are not insured by the FDIC, are not deposits or obligations of, or guaranteed by, E*TRADE Bank or E*TRADE Savings Bank, and are subject to investment risk, including possible loss of the principal amount invested.

System response and account access times may vary due to a variety of factors, including trading volumes, market conditions, system performance, and other factors.